Informal sector

What Is the Informal Sector?

The informal sector refers to the segment of an economy that is not regulated, taxed, or monitored by the government. It encompasses a wide range of economic activities, enterprises, jobs, and workers that operate outside the established legal and regulatory frameworks. This often means that businesses in the informal sector do not register with authorities, do not pay tax revenue, and their workers may lack formal contracts, social protection, or employee benefits. As a crucial aspect of economic development, particularly in developing economies, the informal sector plays a significant role in providing livelihoods, though often characterized by precarious work and low productivity. The International Monetary Fund (IMF) defines the informal economy as "activities that have market value and would add to tax revenue and GDP if they were recorded."¹¹

History and Origin

The concept of the informal sector gained prominence in development economics in the early 1970s. Its origins are often traced to studies conducted by the International Labour Organization (ILO), particularly a 1972 report on Kenya that highlighted the widespread existence and economic significance of unregulated activities.¹⁰ Prior to this, traditional economic models largely focused on formal employment and production. However, as the ILO grappled with defining unemployment and underemployment in developing countries, it became clear that a significant portion of the labor force was engaged in activities that did not fit neatly into formal statistical categories.⁹ The recognition of the informal sector provided a new lens through which to understand employment, poverty, and livelihood strategies in urban and rural areas of the global South. Since then, the ILO has continued to focus on the informal economy, advocating for policies that promote the transition to formality and decent work conditions.⁸

Key Takeaways

• The informal sector comprises economic activities and employment not regulated or protected by the state.
• It is a significant source of employment and income, especially in developing and emerging economies.
• Workers in the informal sector often lack social protection, benefits, and job security.
• Integrating the informal sector into the formal economy is a major policy challenge, aiming to improve working conditions and expand the tax base.
• The informal sector can include a broad range of activities from street vending to small-scale manufacturing.

Interpreting the Informal Sector

Understanding the informal sector involves recognizing its dual nature: it can be a source of resilience and entrepreneurship for those excluded from the formal economy, but it also often signifies vulnerability and exploitation. When evaluating the impact of the informal sector, analysts consider its size relative to the total Gross Domestic Product (GDP) and the proportion of the workforce it employs. A large informal sector can indicate underlying issues such as excessive regulation, high taxation, or insufficient formal job creation. Conversely, its existence provides critical economic opportunities, acting as a de facto social safety net for many.⁷ Policymakers often examine economic indicators to gauge the prevalence and characteristics of informal work within a country.

Hypothetical Example

Consider the hypothetical country of "Economia," where a significant portion of the population lives in rural areas and engages in small-scale agriculture or street vending. Maria is a street vendor who sells handmade crafts. She buys her materials from local suppliers, processes them at home, and sells the finished products directly to customers in the market. Maria does not have a formal business registration, does not pay income taxes on her earnings, and does not have access to formal credit or social security benefits. Her income fluctuates daily, depending on sales. Maria's economic activity, while contributing to the local economy and her family's livelihood, is part of Economia's informal sector. Despite her hard work, she lacks the security and legal recognition typically associated with formal employment, highlighting the challenges faced by many in the informal sector.

Practical Applications

The informal sector is a critical area of study and policy intervention for governments and international organizations. For instance, the World Bank and other development institutions often design programs to support informal workers, recognizing their economic contributions while addressing their vulnerabilities. This support can include facilitating access to microfinance, providing skills training, and working towards the gradual formalization of businesses.⁶ Efforts are also made to extend social protection mechanisms, such as health insurance or pension schemes, to those in informal employment, which traditionally lack these benefits. These initiatives aim to improve the living standards of informal workers and integrate them more fully into the broader economy.⁵

Limitations and Criticisms

Despite its role in providing livelihoods, the informal sector presents significant limitations and faces considerable criticism. A major concern is the lack of social protection and labor rights for informal workers, leaving them vulnerable to economic shocks, poor working conditions, and low wages.⁴ The absence of formal contracts and benefits means these workers often have no access to healthcare, pensions, or unemployment insurance. Furthermore, the informal sector contributes minimally, if at all, to the government's tax revenue, limiting public funds for infrastructure, education, and social services. The Organisation for Economic Co-operation and Development (OECD) highlights that informal workers, particularly those in low-paying jobs, face persistent challenges in transitioning to formal employment and often pass on this vulnerability to their children, perpetuating cycles of poverty and limited human capital development.³ This contributes to higher income inequality within a society.²

Informal Sector vs. Gig Economy

While both the informal sector and the gig economy involve non-traditional employment arrangements, they differ in their structure, regulatory status, and underlying motivations. The informal sector broadly refers to any economic activity that is unregulated and untaxed by the government, often arising out of necessity, lack of formal opportunities, or a desire to avoid regulatory burdens. It includes activities like street vending, small-scale artisan work, or unregistered domestic services. In contrast, the gig economy typically refers to a system of temporary, flexible jobs, often mediated by digital platforms, where individuals are hired for short-term tasks or projects (e.g., ride-sharing drivers, freelance designers). While some gig economy work may fall into the informal sector due to lack of formal contracts or benefits, the gig economy can also operate within formal regulatory frameworks, with platforms handling payments and taxes. The key distinction lies in the deliberate avoidance of formal structures and regulations characteristic of the informal sector, versus the flexible, platform-based nature of the gig economy which can operate formally or informally.

FAQs

What are common activities in the informal sector?

Common activities include street vending, small-scale retail, domestic work, informal construction, artisanal crafts, subsistence agriculture, and unregistered transport services. These activities are typically small-scale and locally based.

Why do people work in the informal sector?

Individuals often work in the informal sector due to a lack of formal job opportunities, low educational attainment, a desire for flexible hours, or to avoid high taxes and complex regulation associated with formal employment. For many, it serves as a crucial means of survival and income generation.¹

How does the informal sector affect a country's economy?

The informal sector can both support and hinder a country's economy. It provides employment and income for millions, particularly in developing economies. However, it also leads to reduced tax revenue, lower productivity, lack of social protection for workers, and difficulties in implementing effective economic policies.

Can the informal sector be measured?

Measuring the informal sector accurately is challenging because its activities are not officially recorded. However, economists use various methods, including discrepancies between income and expenditure data, surveys of household consumption, and labor force surveys, to estimate its size and contribution to the Gross Domestic Product.